Suppose that (εt)t=0,1,…,T is a sequence of independent and identically distributed random variables such that Eexp(zε1)<∞ for all z∈R. Each day, an agent receives an income, the income on day t being εt. After receiving this income, his wealth is wt. From this wealth, he chooses to consume ct, and invests the remainder wt−ct in a bank account which pays a daily interest rate of r>0. Write down the equation for the evolution of wt.
Suppose we are given constants β∈(0,1),AT,γ>0, and define the functions
U(x)=−exp(−γx),UT(x)=−ATexp(−νx)
where ν:=γr/(1+r). The agent's objective is to attain
V0(w):=supE{t=0∑T−1βtU(ct)+βTUT(wT)∣w0=w},
where the supremum is taken over all adapted sequences (ct). If the value function is defined for 0⩽n<T by
Vn(w)=supE{t=n∑T−1βt−nU(ct)+βT−nUT(wT)∣wn=w}
with VT=UT, explain briefly why you expect the Vn to satisfy
Vn(w)=csup[U(c)+βE{Vn+1((1+r)(w−c)+εn+1)}]
Show that the solution to (∗) has the form
Vn(w)=−Anexp(−νw),
for constants An to be identified. What is the form of the consumption choices that achieve the supremum in (∗) ?